OREANDA-NEWS. S&P Global Ratings today raised to 'A-' from 'BBB+' its long-term corporate credit and issue ratings on France-based aerospace and defense company Thales S. A. The outlook is stable.

At the same time, we affirmed our 'A-2' short-term corporate credit rating on the company.

The upgrade reflects our view of Thales' currently solid credit metrics and our expectation that Thales will sustain positive free cash flow in 2016-2017. We think that Thales' financial leeway will be supported by continued growth across all business divisions, steady project execution, and gradually strengthening profitability at group level. This should result in an adjusted funds from operations (FFO)-to-debt ratio well above 60% in 2016-2017, compared with a solid 108% in 2015.

Thales has capitalized on its leading market positions in civil applications, as well as in defense systems, to capture significant order intakes over the past couple of years. As a result, it reported a solid 8.4% revenue progression to €14.1 billion in 2015, including an organic increase of 4.5% after an organic decline of 1.1% in 2014. This positive trend continued in the first half of 2016, with strong 8.9% organic growth. Emerging markets largely fueled the growth, but we also note a return to positive growth in Europe.

Based on its sizable €30.4 billion order book as of end-June--excluding the estimated €2 billion Rafale deal in India--Thales will likely deliver 3%-5% revenue growth in 2017. The share of emerging markets has increased to 28% of total sales from 22% four years ago, and this will help drive growth in the coming years, in our view.

Over the same period, we expect that Thales will continue to strengthen its profitability following five years of steady margin growth. The company targets an improved EBIT margin to 9.5%-10% by 2018, from about 8.6% in 2015. We note that the two largest divisions, aerospace and defense & security, have already achieved or exceeded this target, with 9.6% and 10.7% respectively. We expect that the recovery in the transport division will chiefly fuel Thales' margin growth and think that the company is well positioned to achieve its target. In addition, cost reduction and optimization of research and development through better use of engineering force will help achieve the expected improvement.

Under our revised projections, we expect credit metrics will remain strong despite the significant increase we foresee in the pension deficit in 2016. Compared with €2.3 billion in 2015, we expect that Thales' pension deficit will increase to €3.1 billion by year-end, mainly due to the downward revision of the discount rate in the U. K., where the company had a pension deficit of about €1 billion at year-end 2015.

We expect Thales will generate healthy free operating cash flow (FOCF) of about €500 million per year and maintain its dividend distribution target of 35%-40% unchanged in the near term. Thales generated about €1 billion of FOCF in 2015, supported by reduction in working capital on the back of a €600 million increase in advance payments.

The seasonality of the operations and the uncertainty on customer advances may create significant funding needs from one quarter to another. However, we expect that 2016 cash generation will be supported by the down payment on the Rafale contract in India, which could reach €300 million by our estimate. This should limit working capital-related cash outflows for the full year, although we still expect these will be negative.

As of year-end 2015, our adjustments to debt included roughly €1 billion for operating leases and €1.8 billion for the pension deficit. We deducted about €3.1 billion of cash balances from debt.

We include a positive one-notch adjustment in our rating on Thales to reflect our comparable ratings analysis. We base this adjustment on our expectation that credit metrics will remain strong for the rating and that the company will continue to progress smoothly on strengthening its profitability, in line with peers over the coming years.

Under our criteria for rating government-related entities, including Thales, we continue to view the company as having a limited role for its 26.4% shareholder, the Republic of France. We likewise view the link between Thales and the French government as limited. As a result, we assess a low likelihood of extraordinary government support to Thales in the event of financial distress. Consequently, we do not add any uplift for government support to Thales' stand-alone credit profile of 'a-'.

The stable outlook reflects our expectation that Thales will continue to demonstrate solid credit metrics, with FFO to debt at or above 60% and consistently positive FOCF generation. We also think that the company will further improve its profitability as the legacy contracts in its transport division gradually come down over 2017-2018.

We currently do not foresee ratings upside, but we could consider a positive rating action if the company demonstrated significant improvement in its profitability. Rating upside could also materialize if we changed our view of the importance of Thales' role for the French government following rising geopolitical pressures.

We could lower the ratings if the company underperformed versus our base case, if it posted a significant decline in order intake that would compromise future growth, and its profitability were undermined by project execution or cost overrun problems. Our adjusted FFO-to-debt ratio falling below 50%-55% without near-term prospects of recovery, or a more aggressive financial policy, could also lead us to lower the ratings.